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The Upside of the Investor-Return Gap

The flexibility that individual investors have to capture excess returns gives them an advantage over less-agile institutional investors, says Research Affiliates' Jason Hsu.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We have Jason Hsu. He's a co-founder of Research Affiliates. Jason, thanks for joining me.

Jason Hsu: Thank you for the invitation.

Glaser: We just finished your session here at the Morningstar ETF Conference, and a big theme was this gap in investor returns--a return gap between how value funds perform and what investors actually experience in value funds. How do you explain this persistent gap in the returns?

Hsu: A lot of what we see is that investors want to time and they try to time, and what they do is they both switch in and out of different value managers and, of course, they go from value funds back to growth funds. It's this timing that's creating a return gap--meaning they time really poorly. They get into a manager who's hot recently just before he underperforms, and they move out value funds after a period of underperformance just in time to miss a rebound.

Glaser: What are some of the implications if we have this persistent gap? What does it mean for the factor? Does it mean it's not going to work as well over time? Does it have a real market implication?

Hsu: Interestingly enough, this is actually good news. Of course, a big return gap is bad news for investors, but what it means is that no one's actually extracting the value premium. If all the investors who buy value mutual funds end up supplying alpha--meaning underperforming through their own trading activities--this means there is no one that's "arbing out" the value effect, which means there's a lot more value alpha for those who can truly be buy-and-hold or who can, in fact, be a contrarian in how they invest in value funds and value managers.

Glaser: How do you become that contrarian? What are some strategies that could help you achieve that?

Hsu: I think the first thing you need to do is fight off this human tendency to overextrapolate past performance and make meaning from it. I think a lot of why we buy a manager or a fund is because a manager's been good the last two or three years. Unfortunately, if you look at the data, there's definitely cyclicality to the value factor and to many other styles and strategies. So, you really want to avoid making decisions based on recent performance. But that's really, really hard. I've never heard of someone who says, "I'm going to buy a manager who's been bad the last two or three years." [I've never heard someone say,] "I'm going to get into an asset class that's been underperforming the last two or three years." I think it's just too hard to do because it goes against the grain of our animal spirit.


Glaser: But if everyone works to overcome this animal spirit and we get rid of this gap, would it mean that value might not work anymore and you'd have to look for other strategies? Will there always be this gap?

Hsu: If we all become a lot more rational--more capable of fighting off this animal spirit--then the behavioral aspect of the excess return will gradually dwindle. And of course, it'll dwindle to a level where all you're really getting in any exchange of securities and assets is a fair return associated with the risk. So, I would say we're very, very far from there because the return-gap calculation that [Morningstar's Russ Kinnel] computes regularly remains large and remains fairly constant over time.

Glaser: Is this a scenario in which you think individuals might have an edge over institutional investors--that they can drown out this noise a little bit better?

Hsu: This is actually one area where I think being an individual, which gives you flexibility, can give you a big advantage over an institution. If you look at an institution, the way it makes decisions is based on a committee. There's a lot of structure, and the structure basically goes like this: I use a consultant, he brings in the best-performing managers, and we pick one or two out of that beauty pageant. That's not likely going to change. It's going to require a whole-sale change in how large institutions function. As an individual investor, once you recognize this tendency to time poorly and you recognize the defect of trend-chasing, I think you can fight that by using a better financial advisor, by having better self discipline, by being committed to buy-and-hold. I think you can fight that more effectively as an individual than as an organization.

Glaser: When you're trying to find those contrarian finds, if you're trying to find things that haven't been performing well, how do you know you're buying someone who still has the skill to maybe bounce back over time, versus buying into a strategy that is just not going to work anymore?

Hsu: I think this is where it's really useful to do a bit more research. You shouldn't just look at a manager and say, "He's been very bad recently--maybe he'll mean-revert." That's not going to work well because some managers are really bad simply because they charge really high fees; some managers have had bad performance because they, themselves, are just trend-chasing investors with no well-defined strategy or style. What you want to do is make sure that, if you buy a value manager, he has a really consistent value strategy--a very consistent philosophy. Those will be the ones that would have an opportunity to mean-revert when their philosophy and style comes back in favor.

Glaser: Jason, thanks for joining me today.

Hsu: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.